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How well have interest-rate hedged bond ETFs protected retirees from rising interest rates?

Now's a perfect time to ask, since the 10-year Treasury yield (TNX) has continuously traded above the 3% threshold for more than two months now. It wasn't that long ago—July 2016, for example—when this yield was less than half as high. The last two and one-half years therefore provide a real-world test of these ETFs that were created when interest rates were at rock-bottom levels and only had hypothetical backtested returns.

Another reason the question is important: The judgment of the futures markets is that the federal-funds rate will be at least 50 basis points higher by the end of this coming year.

Overall, I think these rate-hedged ETFs have performed well enough for retirees to give them serious consideration. But you should know that hedging is a messy business, and there inevitably will be times—hopefully temporary—when the hedges don't work.

Consider first these ETFs' performance since July 8, 2016. That date was when the Treasury's 10-year yield hit its all-time low (at least since the early 1960s), closing at 1.37%. The comparable yield today is 3.07%, more than twice as high.

The accompanying chart reports the performance since then of two of the larger rate-hedged ETFs, along with the comparable returns of the unhedged versions of these same ETFs. Notice how in both cases the rate-hedged ETFs did significantly better than the unhedged versions: In the case of the iShares Interest Rate Hedged Corporate Bond ETF (LQDH) the hedges added 4.11 annualized percentage points. For the iShares Interest Rate Hedged High Yield Bond ETF (HYGH) the hedges added 2.98 annualized percentage points.

Notice also that, due in no small measure to these hedges, both of these rate-hedged ETFs made money over this period of significantly higher rates.

That's definitely good news.

You should know, however, that these hedges don't guarantee that you won't still lose money over shorter periods along the way. Consider year-to-date performance: While these two ETFs have done significantly better than their unhedged versions since the beginning of the year, they still are in the red: LQDH fund has lost 2.9% and the HYGH has lost 2.2%.

Why did they lose money? The answer traces to the mechanics of hedging interest rate exposure. Each of these ETFs owns a basket of bonds with different maturities, and hedging that basket requires an implicit bet on the future shape and slope of the yield curve. Such bets can either be better or worse and, needless to say, so far this year these ETFs' hedges haven't been perfect.

You should also know that there is another way in which these rate-hedged ETFs can lose money: Through the default of the companies issuing the bonds the funds own. While that hasn't been a factor in these ETFs' year-to-date losses, it certainly could become one in the event of an economic downturn. This is a particular risk for the rate-hedged high-yield ETFs, of course.

But are interest rates really headed higher?

It's also important to acknowledge that rate-hedged ETFs are also hedged against falling interest rates. That's because, with such ETFs, you know going in that you are forfeiting the gain you'd otherwise realize from falling rates in order to immunize yourself from the loss caused by higher rates.

I say this because it's not as obvious as you might think that rates are headed higher. As I discussed in a Retirement Weekly column last February, after adjusting for inflation and taxes, current interest rates are right in the middle of the historical distribution. One lesson you might draw from this is that interest rates have just as much probability of falling from current levels as rising.

If so, then hedging your interest rate exposure might not be as important as you otherwise think.

Still, it's good to know that, in the event you do think rates are headed higher, rate-hedged ETFs provide a potentially effective way of reducing your losses.

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